Correctly Running a Captive

Have you decided to form a captive? This webpage clarifies certain issues regarding the business plan, purpose, and operation of your insurance company.

It is necessary for your insurance company to be operated as a bona fide insurance company for profit, to be deemed to be primarily in the business of insurance for purposes of the Internal Revenue Code. Your insurance company cannot be a “mere shell” for you to conduct non-insurance company activities, yet claim the favorable tax treatment for insurance companies under the Internal Revenue Code. We cannot, and will not, accept clients whose motivation is to form and hold insurance companies as a “mere shell” to place other businesses into a tax-favored environment.

If your insurance company is not operated as a bona fide insurance company for profit, i.e., if its predominant business activity is not insurance and the purpose and operation of your insurance company does not make good economic sense, you risk the company being deemed not in the business of insurance, in which case you could not take advantage of the certain favorable provisions for insurance companies under the Internal Revenue Code. In such event, your company could possibly be subject to federal income tax on all of its income (with the possibility of “double taxation” as a “C” corporation – or, worse, some type of foreign entity). Therefore, it is critical that your insurance company at all times be operated as a bona fide insurance company for profit, and that insurance activities constitute the primary business of the company.

Please note that if your insurance company is attempting to qualify as an IRC § 501(c)(15) company (which we do not suggest, based on anticipated changes to the tax laws), and your insurance company earns more in investment income that in premiums, it risks being deemed an “investment company” as opposed to an “insurance company”, with the loss of any tax benefits given to insurance companies by Congress. For more information on this topic, please see IRS Notice 2003-35.

One aspect of a bona fide insurance company is that your insurance company will charge a commercially reasonable or “arm’s length’s” rates for premiums on all insurance policies. Charging commercially unreasonable rates for premiums, or premiums that have rates well in excess of those available in the insurance marketplace, could endanger the classification of your company as an insurance company for a variety of purposes, including U.S. tax purposes.

The fact that you will arrange for insurance management and related services, such as actuarial and underwriting services, etc., does not negate the fact that the insurance company must be operated as a bona fide insurance company for profit. It is ultimately your responsibility to maintain your company as a legitimate insurance company whose primary business is that of insurance.

Evidence that your insurance company is a bona fide insurance company for profit will include the fact that your insurance company has retained certain licensed professionals to assist the company in the conduct of its business. Your insurance company should retain certain licensed professionals to perform inter alia the following services:

Insurance management services, including drafting of policies, etc., performed by an insurance manager of your insurance company; and

Accounting and audit services, performed by accountants who are approved in the jurisdiction of domicile of your insurance company.

However, the mere retaining of professionals to act on behalf of your insurance company does not ipso facto place it in the business of insurance. Rather, your insurance company enters the business of insurance by a relatively long and detailed process, which is further described below.

Most U.S. states have relatively high license fees, surplus and capital requirements. While these may be necessary to provide for the fiscal needs of the state, and to protect third party insureds, respectively, these requirements can economically strangle a new insurance company which is attempting to feel its way into the insurance business and has not yet established a book of high profit/low risk business. Therefore, it is often necessary for budding insurance companies to avail themselves of jurisdictions outside the U.S., to the so-called “offshore” jurisdictions that are characterized by minimal licensing fees and relatively low capital and surplus requirements.

Please keep in mind, however, that even though the “offshore” jurisdiction where you will initially domicile your insurance company will have relatively low fees, surplus and capital requirements, this does not mean that your insurance company will not be regulated. To the contrary, the Insurance Commission (or equivalent) of the jurisdiction wherein your domicile your insurance company is apt to have a number of technical requirements relating to minimum surplus and capital, types of policies which can be written, etc., that your company will be required to comply with. While a technical misstep in complying with these rules should not necessary invalidate the characterization of your company as an insurance company under current U.S. tax law, a wholesale failure by your insurance company to attempt to comply with these regulations could indicate that it is not seriously interested in being in the business of insurance, which could jeopardize its status as an insurance company for U.S. tax purposes. Although the local insurance regulators might require a relatively low capitalization for their purposes, the company must maintain adequate surplus to satisfy various aspects of U.S. tax law, especially in regard to “risk shifting” analysis, which might in some circumstances be substantially higher than what the local insurance regulators may require.

Primarily important is the creation and execution of a viable business plan. The execution of such plan is intended to result in the company qualifying as an insurance company. The creation of such a business plan will take into account a number of factors too extensive to be discussed here, but will include the following:

Economic Viability – Your insurance company and its plan of operation must be designed so that company is profitable. For budding insurance companies, such as yours, this will include identification of certain “niche” insurance markets, which are characterized by a level of profitability that is favorably high in relation to a low level of risk being assumed. At the same time, it is important that your insurance company not commit itself to a large amount of risk before it has built up its pool of business and reserves so that the risks can be spread and premiums earned in accordance with conservative underwriting considerations.

Ratings – One of your goals may be to operate your insurance company in such a fashion that it receives favorable ratings by the ratings triumvirate of Standard & Poor’s, Moody’s and Best’s. Typically, these ratings companies will not rate a new insurance company for a period of at least several years after the company has been formed. When the companies are rated, there are at least three factors that are critically important:

The level of competence of the insurance company’s management to-date (i.e., that the insurance company has been managed in a competent fashion, and has an underwriting history which tends towards profitability without putting reserves or surplus at risk of a serious loss);

The maintained level of the insurance company’s capital and surplus (the higher the level of capital and surplus, the higher the rating your insurance company will likely receive); and

The outstanding risks and liabilities of the insurance company (the lower the level of outstanding risk and liabilities, the higher the rating your insurance company will likely receive).

Please note that the ratings your insurance company may receive from Standard & Poor’s, Moody’s and Best’s may create substantial additional value in your insurance company, as highly-rated insurance companies command a much higher sale value. This should motivate you to operate your company in a conservative fashion, as described above, so as to obtain these ratings.

Underwriting Activities –It is important that your new insurance company does not overextend itself, by accepting risks which are outside the company’s experience level. New insurance companies should usually attempt to limit themselves to underwriting the otherwise uninsured risks of related-party businesses (i.e., providing insurance for other businesses which you own or control, and for which you understand the risks and are currently self-insuring). You may also investigate participating in reinsurance pools as well as underwriting in the securities and financial markets in which you have expertise.

Investigation of “Niche” Insurance Opportunities – You should be prepared to locate and analyze certain opportunities to offer insurance in currently untapped or noncompetitive markets. Indeed, your desire to enter the insurance market in such niches should be one of your primary motivations in forming a new insurance company.The creation of the business plan for your insurance company is merely the first step towards qualifying your company as an insurance company. After licensing, your primary business must be that of insurance. Your insurance company must be operated in accordance with the business plan, and as a bona fide insurance company for profit, actuaries, underwriters, insurance managers, and accountants, etc.

IRS Guidelines and Requirements — The IRS is continually modifying the definition of what qualifies as an “insurance company”. In order to qualify as an insurance company, at a minimum your company will have to insure at least twelve brother-sister corporations, or underwriter at least 29% third-party risk (at least 50% is preferable). These merely represent two of a multitude of tests that your company must meet to qualify as an insurance company for Internal Revenue Service purposes.